Federal banking regulators have issued an advance notice of new rules that would use alternatives to credit ratings in setting capital standards for banks.  According to the notice, the Dodd-Frank Wall Street Reform and Consumer Protection Act requires banking regulators to review their rules that make reference to credit ratings and then modify those rules to “remove any reference to, or requirements of reliance on, credit ratings.”  The notice from bank regulators follows on the heels of a similar announcement from insurance regulators.

This is important.  The rating agencies Moody’s and S&P were a major source of extreme volatility in the recent crisis, because too many investors, financial institutions, and regulators relied on the validity of their ratings for mortgage-backed securities.  As I point out in “Stalking the Black Swan,” too many people believing in the same idea or following the same process can produce Black Swan-like outcomes, if the idea or process turns out to be invalid.  If banks and insurance companies have to come up with their own determinations of the credit worthiness of the securities they hold, then it will reduce the reliance placed on Moody’s and S&P, making the financial system a little less fragile.

I was surprised to see chief regulators complaining about this change.  They point out that small banks don’t have the “expensive risk management models” used by large banks, so switching from credit ratings will be a difficult endeavor. 

May I suggest that perhaps small banks should not hold securities that require complicated models to evaluate? 

During our recent downturn, small banks were hit with losses from holding CDOs of trust preferred securities or securitization tranches from pools of risky mortgage loans.  They had relied on credit ratings that turned out to be inaccurate.  Losses on these holdings contributed in some cases to bank failures and thus losses for the FDIC deposit insurance fund.  Under the new law, small banks will have no business investing in risky assets, unless they want to spend money on the research and analysis necessary to make independent judgments.